Is the Cycle Turning for Small-Cap Stocks? | ETF Trends

Current valuations are setting up a potential run of long-term outperformance for small- and mid-cap stocks.

The Tide Turns in Favor of Small-Cap Stocks

Large-cap stocks have had an extended period of outperformance, which has resulted in large-cap indexes becoming concentrated in a few large mega-cap stocks, primarily in the technology sector. Indeed, it’s been quite a run for large caps, but this phenomenon of large cap outperformance has created an imbalance in U.S. stock markets. Following the recent period of volatility, large caps (particularly tech) have been hit hard, and small- and mid-caps have started to outperform. And there is good reason to believe that this recent turn in leadership will mark the beginning of a new period of long-term outperformance for small- and mid-cap stocks.

Relative Valuations for Small-Caps Haven’t Been This Attractive Since the “Dotcom Bubble”

As Barron’s recently explored in the article, Small-Cap Stocks Are Set for Big Gains, valuations for small- and mid-cap companies are extremely low relative to large caps. In fact, the last time the relative price to earnings for small-caps versus large caps was this low was the “Dotcom Bubble” of the early 2000s. Pair this extreme valuation discount with eventual brighter days in terms of macro backdrop, and we believe small- and mid-cap (SMID-cap) stocks may prove to be rewarding for patient investors.

Small-cap stocks proved to be a wise investment during the 1970s when the Federal Reserve was battling with rampant inflation. This could paint a promising picture for investors looking to navigate current economic conditions. Small-caps tend to have higher exposure to businesses that benefit from rising inflationary pressure, including energy companies, which are often positively impacted when inflation rises. Additionally, small-cap companies are often domestically based and generally more invested in updating capital spending, which gives them an advantage if manufacturers continue transitioning their factories back into the U.S. While past performance is not a predictor of future outcomes, this data provides a favorable historical foundation for assessing the track record of small- and mid-cap stocks.

How to Access Small- and Mid-Cap Stocks

There are about five times as many small- and mid-cap stocks as there are large-cap stocks. Additionally, in the large-cap space, information dissemination and absorption has become highly efficient, but this is not the case as one moves down the capitalization scale. The average small- and mid-cap stock has fewer than eight analysts covering and writing research or recommendations on it, and about one-fifth of these companies have no more than three analysts covering them (the average large-cap company has roughly 21 analysts covering it). This lack of analyst coverage results in a potentially greater dispersion between stock prices and fair value that can prove rewarding for investors. Accordingly, we believe investors seeking to make an allocation to small- and mid-sized companies should look for a strategy that does more than just provide broad-market exposure. We believe a focused approach that selectively identifies companies by considering competition and competitive advantages as well as valuations may be a better choice.

The VanEck Morningstar SMID Moat ETF (SMOT) targets SMID-cap companies with long-term competitive advantages, known as moats, and attractive valuations. SMOT is currently trading at a weighted avg P/E ratio of roughly 14, which is far below the 20 times earnings of the S&P 500 Index.1 SMOT’s underlying index, Morningstar® US Small-Mid Cap Moat Focus IndexSM, also exhibits fewer companies with negative earnings, accounting for about 13% of the index, compared to over 30% for the Russell 2000 Index.2

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Originally published 15 December, 2022.
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1 Source: FactSet. Data as of 11/30/2022.

2 Source: Morningstar Direct. Data as of 11/30/2022.

Morningstar US Small-Mid Cap Index consists of US stocks representing the bottom 27 percent capitalization of the investable universe. S&P 500 Index consists of 500 widely held common stocks covering industrial, utility, financial and transportation sector. Russell 2000 Index represents the 2000 smallest U.S. companies in the broad–based Russell 3000 index.

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